Caution signs expected from Microsoft

MikeTarsala

REDMOND, Wash. (CBS.MW) -- Microsoft may be able to drive past earnings expectations when it reports its second-quarter results Thursday, but analysts say economic worries will force the company to put out the caution cones for early 2003.

Personal computer sales appear to have perked up in the December quarter, with a corresponding spike in software sales, says Richard Williams, analyst with Summit Analytic Partners. That could help Microsoft report better-than-expected net income.

But the big fear for shareholders, according to Williams, is that Microsoft executives won't be able to say that stronger customer spending and an economic recovery is coming in the first half of the year. He expects Microsoft shares to suffer as a result.

"The company's stock valuation shows that shareholders expect to see a huge revival or recovery, starting in the fourth quarter, and continuing into the following two quarters," Williams said. "But recent channel checks show only a seasonal sales uptick. In no case have we seen that there's an accelerating recovery going on."

Microsoft shares
MSFT, -1.70%
rose 62 cents to $55.65 late Thursday, ahead of the earnings announcement expected at the close of trading. The stock has risen 36 percent from its late-July low of $41.41, but has fallen from a price of $70 a share in January 2002.

Analysts polled by Thomson First Call expect the software maker to earn 46 cents a share on sales of $8.59 billion. The company earned 49 cents a share on sales of $7.74 billion a year earlier.

Where it looks good

Business could be looking up for Microsoft in certain areas. The world's largest software maker may report a spike in sales of its Xbox game consoles, helping the company boast as much as 50 percent year-over-year growth in its Home & Entertainment division. Most analysts see better Xbox sales as a positive, even though the company continues to lose money on every console it sells.

Management may also be able to tout its progress in sweeping legal issues under the rug. The company last week proposed a settlement to 27 class action suits it faces in California, at a cost of as much as $1.1 billion. And a federal judge said Wednesday that the company must release an updated version of Sun Microsystems' Java programming language for Windows. Microsoft and Sun continue to negotiate and appear to be working toward an agreement.

"We see getting these legal issues behind the company as a huge positive, but do not expect it any time soon," said Deutsche Bank analysts in a research note issued to clients Wednesday.

Management is likely to tout its many new products on its earnings conference call -- even though many of the wares have yet to contribute significantly to sales. The company introduced the Tablet PC in November, and has since demonstrated Microsoft's software on a variety of consumer products, from watches to key chains.

But despite the positives, analysts say Microsoft faces business uncertainties in the near future. Analysts are questioning where the company can generate the next big wave of corporate contract signings.

Microsoft benefited in the December quarter from what could be the last batch of multiyear software contracts signed under a new licensing plan that took effect in August. That resulted in abnormally strong September quarter revenue and earnings, according to John Connors, the company's chief financial officer.

Going forward, Williams expects Microsoft to be cautious with its financial targets, warning of economic uncertainties that could hinder the rate of corporate software licensing. He expects management will make no changes to earnings and sales targets.

If that happens, it wouldn't be enough to move Microsoft shares higher in the short term, he says.

High multiple

Microsoft trades at 29 times earnings, and at a price-to-earnings-to growth ratio of three times 2003 expectations. Williams says the multiples are in order for a company increasing revenue by 30 percent every quarter -- but not one that's boosting it by 10 to 12 percent a quarter, like Microsoft.

Merrill Lynch analysts project Microsoft's largest business group, its desktop revenue, will see a 9 percent decline from the previous quarter to $2.55 billion. The brokerage expects that will be partially offset by a 6 percent sequential rise in server software sales, to $1.7 billion.

Some shareholders may be tuning in to Microsoft's conference call immediately after the company's earnings release to see if management will bow to pressure to pay a stock dividend.

Microsoft has accumulated a war chest of more than $40 billion in cash to use for dividends, acquisitions, stock buybacks or any purpose management sees fit. Any dividend or buyback could help to raise the company's stock price in the coming months.

But Microsoft's management has been reluctant to say it's likely to pay a dividend, even if the White House is successful in enacting legislation that would end investor taxes on dividends, giving the company a bigger incentive to pay one.

And another large stock buyback also may be unattractive, due to Microsoft's high stock price, says Sameer Bhasin, analyst with Okumus Capital Corp. in New York.

"The stock is trading at nearly a 50 percent price-to-earnings premium to the rest of the market," Bhasin says. "Why would they want to buy the stock back right now? It's not cheap."

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